Bill D'Alonzo knows a good growth stock when he sees one. The 50-year-old CEO of Friess Associates runs one of the best performing large-cap growth mutual funds, Brandywine Blue, which has gained 14.3% this year. Friess manages $8.6 billion, which includes the Brandywine Fund. Personal finance writer Lewis Braham recently caught up with D'Alonzo in his office in Greenville, Del., to discuss his investment strategy. Following are edited excerpts from their conversation
Q: A number of money managers I've spoken to have said that blue chips such as Wal-Mart (WMT ), McDonald's (MCD ), Citigroup (C ), and Pfizer (PFE ) now trade at price-earnings ratios that aren't much higher than that of the market as a whole. Is it time to buy brand names again?
A:A dollar earned by Wal-Mart isn't worth more than a dollar earned by any other company, so the fact that Wal-Mart and other big-name companies sell at less of a premium than they used to doesn't get us excited. Brandywine Blue is a little different in that it typically doesn't hold the mega-cap blue chips that are common in most other large-cap growth funds. The mega-cap stocks usually grow too slowly to meet our growth standards and tend to be followed by a hoard of analysts, making it harder for us to gain the information edge that's central to our approach.
Still, we do own big-name companies when they represent appealing opportunities. We bought McDonald's in October at a price-earning ratio of less than 15 times 2005 estimates, a reasonable price regardless of the company's reputation. Many investors appeared to deem the McDonald's turnaround story was over last spring, but the company appears to have taken advantage of its tough times to look internally and make thoughtful changes.
It's accepting credit cards. And it's making itself more appealing to parents by revamping its salads to be appetizing, healthier options for them while taking the guilt out of kid's meals by offering apples and bottled milk as alternatives to fries and soda. At the same time, products such as the McGriddle show that McDonald's is not abandoning its other customers.
Q: Do you see growth stocks finally beating value in 2005?
A:For us, earnings growth determines whether a company falls into the growth camp. Some other folks consider high p-e ratios, industry affiliation, and other factors unrelated to individual-company fundamentals as the marks of a growth stock, so it's hard for us to say whether "growth" in general is poised to outperform since we don't all use the same definitions.
That said, we saw the tail end of the bear market in 2002, a speculative rally fueled by the economy's turn for the better in 2003, and an environment in which oil prices, the election, and other macroeconomic factors overshadowed strong earnings growth for much of 2004. Now, we expect moderate economic growth and, we hope, less macro noise in 2005. That will put investors in a position to evaluate each company on its own merits. In such an environment, above-average earnings growth should attract attention, especially in instances when it sells at a reasonable price.
Q: What are some of your favorite sectors and stocks?
A:We don't have favorite sectors, or even favorite stocks. We are bottom-up investors who seek companies experiencing rapid earnings growth regardless of what sector they occupy. We might love a stock today and sell it tomorrow if its fundamentals deteriorate or a new opportunity with greater upside potential displaces it.
Brandywine Blue's portfolio adapts to reflect the changing earnings landscape. Earlier this year we sold some technology holdings, as their earnings fortunes began to peak, in order to fund new opportunities with improving earnings prospects, most of which we identified in the energy and raw materials sectors.
We purchased oil-field service provider Weatherford International (WFT ) in April and still hold it today. June- and September-quarter earnings grew 29% and 40% percent from year-ago levels, beating consensus estimates both quarters. Weatherford's new yield-improving technologies are in strong demand as drillers worldwide increase production to capitalize on higher energy prices.
We also bought copper-mining company Phelps Dodge (PD ) in June. Quarterly earnings this September jumped to $2.95 per share, up from just 6 cents a year ago. The company is benefiting from consistently strong copper demand and tight supplies. At the time of our purchase, a single copper mine in Indonesia responsible for roughly 5% of the world's production was shut down following a massive slide. After recently restarting, the Indonesian producer reported its production costs would be 10% higher than previously forecast.
As production costs rose elsewhere this year, Phelps Dodge made investments that will lead to lower production costs in 2005, fueling opportunities to expand its profit margins as margins contract among its competitors. This is a particularly promising situation, as Phelps Dodge is the only copper producer currently in a position to increase incremental copper supply.
Q: For the past few years, small-cap stocks have beaten large-caps. Do you see this trend persisting in 2005?
A:From a valuation standpoint, there are more promising opportunities in the large-cap arena. The average S&P 500 company sells at 17 times 2005 earnings estimates with analysts forecasting just 6% growth, but an investor focusing on the individual-company level can do much better in terms of price and earnings power. For example, the average Brandywine Blue holding sells at less than 15 times 2005 estimates with 23% earnings growth expected. We aim to uncover companies that will exceed consensus estimates, so Blue's average holding's p-e is lower and its growth rate is even higher based on our own estimates.
Q: What are the keys to being a successful growth stock investor in this environment? Has your strategy changed at all since the bear market?
A:We don't change our stripes to suit the environment. We consistently focus on earnings trends on the individual-company level, which enables us to migrate to pockets of earnings strength as conditions shift. The portfolio changes, but the strategy doesn't.
We isolate companies experiencing rapid earnings growth with good prospects to exceed Wall Street earnings estimates to capitalize on the relationship between earnings performance and stock prices. Beyond that, we focus on those rapidly growing companies that sell at reasonable multiples of earnings estimates to maximize upside potential and mitigate downside risk.
Earnings growth defines whether a company is a growth stock to us. Given the choice between a semiconductor company selling at 30 times earnings estimates with 10% earnings growth and a shoe retailer selling at 10 times earnings with 30% growth, we'll take the shoe retailer without hesitation.